By Jonnelle Marte
(Reuters) - U.S. Federal Reserve Vice Chair Randal Quarles said Thursday policymakers should consider changes that would make it easier for banks to treat Treasury holdings as similar to reserves held with the central bank when meeting liquidity requirements.
Quarles listed several options Fed officials could adopt to give financial firms more flexibility when meeting liquidity requirements while not loosening the standards for how much liquidity banks need to hold, Quarles said in New York.
"I think it is worth considering whether financial system efficiency may be improved if reserves and Treasury securities' liquidity characteristics were regarded as more similar than they are today," Quarles said in prepared remarks for an event organized by the Money Marketeers of New York University.
"To be clear, the ideas I will discuss do not involve any decrease in banks’ liquidity buffers," he said.
For example, Quarles said Fed officials could adopt a policy where financial firms are sometimes allowed to include the discount window, a backup source of funding from the Fed, as part of their liquidity planning during stress scenarios. The discount window is rarely used because some firms fear there is a stigma associated with it, but Quarles said an adjustment could give banks more incentive to incorporate the tool.
A liquidity crunch in mid-September disrupted money markets and led to a spike in short-term borrowing rates. The Fed calmed markets by injecting billions of dollars into the markets for repurchase agreements, or repo. Officials also moved to permanently increase the level of reserves in mid-October by purchasing $60 billion a month in short-term Treasury bills.
Fed Chair Jerome Powell said last week that the repo operations are likely to continue until April and that the pace of Treasury purchases could slow in the second quarter as the central bank reaches an "ample" level of reserves, or when Fed can control interest rates without needed to conduct frequent open market operations.
Quarles said unexpected friction in money markets that appeared in September suggested that more reserves were needed in the banking system. Still, he said he would prefer for the Fed to keep the balance sheet as small as possible.
"I believe that balance sheet policies are more credible if we can show that there is not a persistent ratcheting-up effect in the size of the Fed’s asset holdings," he said.
Some analysts were concerned there could be a repeat episode of volatility in the repo market at the end of last year, when large banks were expected to pull back on lending in short-term markets in an effort to shrink their balance sheets and avoid capital surcharges.
Quarles said Thursday that Fed officials are "actively considering" a change that could address that issue by relying less on year-end inputs and more on average figures when evaluating liquidity requirements for globally systemically important banks.
The policymaker said officials are still considering a standing repo facility, which would make it easy for dealers to swap Treasury holdings for cash. But he said, "There may be benefits to working first with the tools we already have at our immediate disposal."
Quarles also said he thinks interest rates are at a good level to support economic growth following the three rate reductions approved by the central bank last year. Fed officials voted last week to leave rates steady at a target level of 1.50% to 1.75%.
"I view the current stance of monetary policy as appropriate given the economic outlook and relatively muted inflation pressures," he said.
The policymaker said he is "optimistic about the outlook" and expects inflation to reach the Fed's 2% target over the medium term. However, he said there are "notable risks" threatening the economy, including weak business investment, shifting trade policy and the spread of the coronavirus.
"It is too early to say what the full economic effect of the outbreak will be, and this situation will require careful monitoring," he said.